Monday, March 26, 2012

Hedge Funds Capitulating, Bullish on Stocks?

Hedge funds trailing the Standard & Poor’s 500 (SPX) Index for the last five months are giving up on bearish bets and buying stocks at the fastest rate in two years.

A gauge of hedge-fund bullishness measuring the proportion of bets that shares will rise climbed to 48.6 last week from 42 at the end of November 2011, the biggest increase since April 2010, according to data compiled by the International Strategy & Investment Group. The Bloomberg aggregate hedge fund index gained 1.4 percent last month, lagging behind the Standard & Poor’s 500 Index by 2.65 percentage points.

Money managers struggling to catch up with the gains have contributed to the rally that pushed the S&P 500 up 27 percent since October as economic reports beat estimates. Market bulls say they are a continuing source of cash that can move stocks higher. Bears say capitulating hedge funds are further evidence that equities have risen too far, too fast as economic growth remains sluggish, warning that the pool of potential buyers is being depleted.

“It’s encouraged me to gradually increase my exposure to stocks,” Barton Biggs, founder of hedge fund Traxis Partners LP in New York, said in a March 23 phone interview, referring to an improving economic outlook. “The shift has occurred gradually in the six or so months since the beginning of October. I’d be inclined to raise my net long further because the potential to the upside would be greater” should the S&P 500 fall 5 percent to 7 percent, he said.

Biggest Shorts

Short bets reached a five-year peak in October 2008 just before the S&P 500 started a rally that has lifted it 107 percent over three years, according to data compiled by ISI and Bloomberg. Hedge funds trailed the index for six of the first seven months of that advance. Overall short interest reached 4.86 percent of outstanding U.S. shares in July 2008, according to data compiled by NYSE Euronext.

Companies with the most shares borrowed and sold by short sellers have led this quarter’s rally as gains forced bearish traders to repurchase them. Sears Holdings Corp. (SHLD) has returned 128 percent for the biggest gain in the S&P 500 as short interest fell to 8.8 percent of outstanding shares, the lowest since August 2010, according to New York-based Data Explorers. Bank of America Corp. (BAC) and Netflix Inc. (NFLX) have each increased more than 73 percent and seen a drop in pessimistic bets this year.

‘Maximum’ Bullish

ISI’s index, based on a survey of 36 mostly U.S. hedge funds with about $89 billion under management, tracks net exposure on a zero through 100 scale. Readings of zero show “maximum” short selling, while 100 means “maximum” bullish bets. At 50, hedge funds are deploying a “normal” ratio of long to short investments, according to ISI.

The S&P 500 slipped 0.5 percent last week to 1,397.11, the first decline since the five days ended Feb. 10, after manufacturing contracted more than forecast and China raised fuel prices. The benchmark gauge for U.S. equities is on track for the best first-quarter gain since 1998, according to data compiled by Bloomberg. Futures on the index advanced 0.2 percent at 8:21 a.m. in London today.

Investors placed $70.6 billion with hedge fund managers last year, pushing industry assets to $2.01 trillion, according to Chicago-based Hedge Fund Research. The total has risen another 5 percent in 2012 through February. Hedge funds are largely unregulated investment vehicles that aim to make money whether markets rise or fall. The fund managers, who may buy or sell any asset, charge annual management fees, traditionally 1.5 percent to 2 percent, and receive a portion of investment gains equal to 20 percent.

‘Missed It’

“These people have missed it again,” Philip Orlando, chief equity strategist at Federated Investors Inc., which oversees about $370 billion, said in an interview at Bloomberg headquarters in New York on March 20. “They’ve been unduly bearish in their outlook. That’s certainly come back to hurt them.”

While equities gained as the world’s largest economy began expanding in the second half of 2009, helped by President Barack Obama’s stimulus measures and the Federal Reserve’s easy money policies, it’s been the smallest post-recession recovery rate since at least the 1940s, according to Bloomberg data.

Bruce McCain, at KeyCorp in Cleveland, says that even though a slower-growing economy is better than a recession, the 27 percent gain in the S&P 500 since October isn’t justified and stocks will probably drop before they climb.

‘Too Much Enthusiasm’

“There should be a pullback, there’s been just too much enthusiasm,” McCain, who helps oversee more than $20 billion as chief investment strategist at the private-banking unit of KeyCorp in Cleveland, said in a March 22 phone interview. “One of the last parts of the rally is when people throw in the towel and buy into it, and there is that risk for the hedge funds right now.”

For Paulson & Co., the hedge fund founded by billionaire John Paulson, taking a more bullish stance on the U.S. economic recovery last year meant record losses. One of his largest funds declined 51 percent in 2011, prompting the manager to reduce risk just as markets stabilized. Since then, Robert Lacoursiere, the partner who oversaw the $23 billion hedge fund’s team of banking analysts, quit to start his own fund.

Trading volume has plunged this year, with about 768.44 million shares a day changing hands on the New York Stock Exchange in the 50 days through March 5, the least since 1999, Bloomberg data show. While bears say that’s an indication investors lack confidence in the rally, bulls say it means more money is available to be lured back to equities.

‘On the Sidelines’

“It’s been pretty painful to sit on the sidelines,” Walter Todd, who oversees about $950 million as chief investment officer at Greenwood Capital in Greenwood, South Carolina, said in a March 20 phone interview. “It’s one of the reasons we’ve gone as high as we have without correction. Any little pullback in the market has been bought. You’ll continue to see that with the hedge funds and others, there’s a lot of money that’s not in the market right now.”

Investors may be convinced to increase stock purchases after Fed Chairman Ben S. Bernanke raised his assessment of the economy this month and signaled he would keep benchmark rates near the record zero percent through late 2014. The easing has damped demand for the perceived safety of U.S. Treasuries, (USGG10YR) which lost 1.4 percent so far this quarter, compared with the 11 percent rally in the S&P 500. Equities haven’t beaten bonds by that much since the last three months of 2010.

U.S. Growth

Economists estimate the U.S. expanded 2 percent in the first quarter, five times the rate of a year ago, according to forecasts compiled by Bloomberg.

“The search for returns versus low yields on bonds is certainly helping drive the rally, and there is certainly a fear of having missed the rally that’s feeding on it, especially among hedge funds,” said Dennis Leibowitz, managing general partner at Act II Partners LP, a New York-based hedge fund that oversees about $400 million. “We have moved exposure up steadily since fall as a result of the settlement of European- related high anxiety and volatility, and improving U.S. economic numbers.”

The five-month stretch of trailing the S&P 500 is the second-longest in data going back to 2005. The longest was when hedge funds lost to the index for six months from September 2010 and February 2011, according to data compiled by Bloomberg. The equity index rallied 26 percent over that period, compared with an 11 percent advance for hedge funds.

Sears Rally

Sears, the department-store chain based in Hoffman Estates, Illinois, missed analysts’ average earnings estimates for seventh straight quarter and said it plans to close 62 stores in the first half of this year to cut costs. The shares are up 128 percent in 2012 after losing 56 percent last year.

Netflix shares gained almost seven times as much as the S&P 500 in 2012 even after consumers grew angry about a 60 percent increase in prices for the online and mail-order video-rental service and canceled subscriptions last year. The stock tumbled 79 percent from a high of $298.73 on July 13 to November last year. Short selling in the stock decreased to 8.1 percent of outstanding shares last week from 20 percent on Feb. 1, 2011, according to data compiled by Bloomberg and Data Explorers.

Bearish bets on Bank of America, the second-biggest U.S. lender by assets, fell to 1.2 percent from a two-year high in February. The stock has climbed 77 percent this year and topped $10 for the first time since August, pushed higher after the Charlotte, North Carolina-based company passed Federal Reserve stress tests.

“Hedge funds are at least part of the underlying strength in the recent move, and it has to do with not only buying stocks, but first and foremost covering,” Michael Holland, chairman and founder of New York-based Holland & Co., which oversees more than $4 billion, said in a March 22 phone interview. “It’s been a brutal time to be on the short side.”

Are hedge funds truly capitulating and buying up risk assets? Yes, they're dumping Treasuries in droves and chasing stocks at higher levels, fearing they'll underperform once again. The Dow Jones Credit Suisse Core Hedge Fund Indexes show that L/S Equity hedge funds were down 2.8% MTD in March. Most of these hedge funds got screwed shorting this market (click on image to enlarge):

Where did they go wrong? They basically underestimated the world's largest and most powerful hedge funds -- ie. central banks -- who pumped up the jam and unleashed a liquidity tsunami to help out the big banks who have been trading risk assets, profiting off money for nothing and risk for free.

The top hedge funds also participated in this rally, switching gears in Q4. Apart from tracking the quarterly 13-F filings of top hedge funds and long-only funds, I regularly look at weekly data from the WSJ's short interest highlights, showing me which stocks are being heavily shorted and which ones are experiencing a large decrease in short interest.

Sometimes stocks are being shorted for good reason, and other times it's blatant manipulation at its worst as brokers short to keep the price low, allowing their top clients to scoop shares on the cheap. Regardless, when a liquidity tsunami comes, most short-sellers cover, which is why it's important to pay attention to short interest on certain stocks in key sectors.

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